Risk Management & Real Options VIII. The Value of Flexibility Stefan Scholtes Judge Institute of...

Risk Management & Real Options

VIII. The Value of Flexibility

Stefan ScholtesJudge Institute of Management

University of Cambridge

MPhil Course 2004-05

2 September 2004 © Scholtes 2004

Course content

I. IntroductionII. The forecast is always wrong

I. The industry valuation standard: Net Present Value

II. Sensitivity analysisIII. The system value is a shape

I. Value profiles and value-at-risk charts

II. SKILL: Using a shape calculatorIII. CASE: Overbooking at EasyBeds

IV. Developing valuation modelsI. Easybeds revisited

V. Designing a system means sculpting its value shapeI. CASE: Designing a Parking Garage

III. The flaw of averages: Effects of

system constraintsVI. Coping with uncertainty I:

DiversificationI. The central limit theoremII. The effect of statistical

dependenceIII. Optimising a portfolio

VII. Coping with uncertainty II: The value of information

I. SKILL: Decision Tree Analysis

II. CASE: Market Research at E-Phone

VIII. Coping with uncertainty III: The value of flexibility

I. Investors vs. CEOs

II. CASE: Designing a Parking Garage II


Project design

Designing a project means sculpting its risk profile

Histogram

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Values

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Design 2

Value-at-risk chart

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Target value

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Design 1

Design 2


Design parameters

Where?

When?

How big?

With whom?

Etc.


Timing

A key issue is the timing / phasing of investments• When is the right time for which decision?

What is a decision in the first place?

A DECISION IS A COMMITMENT OF RESOURCES

NPV analysis leads us into one-off thinking• Take one decision (invest, yes/no), then the project evolves on a

fixed plan

NPV does not capture value of staging the investment• Many decisions enable you to make further decisions downstream• Commit money to “buy an option” vs. “buy cash flows”

Option: “Right but not obligation to an action in the future”


Pros and cons of waiting

Waiting with a decision allows you to learn / gain information• Reduce risk

Waiting can lead to loss of revenues during waiting period

Waiting can lead to loss of competitive advantage• First mover advantage, pre-emption

Need to trade-off “costs of waiting” against “value of waiting”• No obvious solution• Needs case-by-case analysis


Options

Postponing a decision is about keeping your option open

An option is a “right but not an obligation to a certain future action”

R&D activity buys you the option to launch a product in the future

• if and when R&D is successful and the market is right• VC portfolios are portfolios of options

Foreign direct investment offers you the opportunity to learn about the foreign market and invest in the future in a big way, if and when you believe the time and circumstances are right


Examples of option values

Typical pattern: • Price of option is low relative to the possible gain• If you buy an option you should realise that there is a good chance

that you never exercise it An option is a gamble

“Compound option”: Series of increasingly more expensive stages, followed by a big “final” decision

• VC investment rounds, followed by IPO• Phases of drug R&D• Exploration in oil and gas

Similar to “value of information”• Additional information has only value if you have the option to act

in the future in the light of this information


Options “on” systems vs. options “in” systems

Options ON systems: • Invest a relatively small amount of money for the possibility to

invest a large amount later• Example: R&D is an option to invest in launch, venture capital

investments

Options IN systems:• You are already committed to a large expenditure and can now

improve its risk and opportunity profile by adding design features• Many design features can be seen as options, i.e., giving you the

right but not the obligation to use them in the future• Examples: Y-junction in an underwater pipeline, extra strong

footings for parking garage expansion, etc.


Diversification vs. Flexibility

Three main risk management approaches• Diversify: passive risk / opportunity management• Remain flexible: active risk / opportunity management

Diversification is important if you don’t have control over the fate of your investment

• Owner of a fleet of ships, investor in shares• Dealt with in finance class

Flexibility is important if you are in control• Captain of the ship, CEO of company

Flexibility can increase the value of each individual project and therefore the value of the portfolio of such projects

• That’s why VC’s are interested


Flexibility

Flexibility is more important for managers than for investors• Managers are more likely to be held responsible for the fate of one /

few big projects then for the fate of a portfolio of many investments

Flexibility is only helpful if it is used skilfully in the future• That’s why VC’s are so interested in the quality of the management

team

Flexibility is only valuable if there is uncertainty about the future

• The more uncertainty there is the better for the skilful manager• Avoid downsides, amplify upsides, beat the competition

A good captain likes a stormy sea…


Option value: A stylised example

You own an oil reservoir, what’s the value

What’s the value if• Volume 10 M bbl – no uncertainty• If you pump oil out, it will cost you $39/bbl – no uncertainty• Oil price projection is $40/bbl – no uncertainty

What’s the value if there are two price scenarios with 50/50 chance:

• Oil price can go up to $45 or down to $35• Does the uncertainty increase or decrease the value?

What’s the value if the uncertainty in oil prices increases?• Upside scenario $50, downside scenario $30 • Does additional uncertainty increase or decrease the value?


The options view of capacity

Decide on capacity of new plant

Cost of capacity: $500 / unit production capacity

Operating margin: $600 / unit sold

Projected demand 60,000 units

What’s the optimal design?






Projected demand 60,000 units

What’s the optimal design?• Gain $100 for each unit capacity up to 60,000 units• Build 60,000 units capacity• Value = 60,000*$100= $6 M






Projected demand• 40,000 units – 50%• 80,000 units – 50%

What’s the expected value of the chosen design?







What’s the expected value of the chosen design?• Upside 60,000*$100 = $6M• Downside 40,000*$100 – 20,000*$500 = -$6M• Average value = $0 Flaw of averages







Can we improve on our design?







Can we improve on our design?• Gain $100 up for each unit of capacity up to downside demand of

40,000• Loose on average for each unit of capacity above 40,000

Q̵ Expected loss per unit = 50%*$600-$500=-$200



Optimizing Capacity

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Capacity

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Single Scenario Tw o Scenarios



Risk Profiles of Designs

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Realised Value

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Small

Plus: Building small avoids downside riskMinus: Building small reduces upside potential



Smart solution: Build small but allow for later expansion

Suppose after demand scenario has been observed, 50% of excess demand can still be captured through expansion

How should we stage and what’s the value of the staged project?



No uncertainty after demand scenario has been observed• Build 50% of excess demand as expansion capacity

Optimizing initial capacity:

Design Optimization

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Initial Capacity

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Risk Profiles of Designs

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Realised Value

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Two-stage



Expansion capability is an option on demand

Value of the option: (=) value of the best two-stage design

(-) value of the best one-stage design

(=) $5,000,000 – $4,000,000 = $1,000,000

May have to invest some of the option value in advance to “buy” the option

• Trade-off between price and value of the option



Options are the more valuable the more risky the environment

Uncertainty level = Distance between the two demand scenarios

System and option value as a function of uncertainty level

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Uncertainty Level = Percentage Deviation Up or Down from Projection

Value of non-staged system Value of staged system Option Value


Summary

Options allow you to exploit upsides and avoid suffering from downsides

Option value increases with increasing uncertainty

Options need to be thought of in the initial design phase

Trade-off cost of the option with its value

NOW TO A CASE: PARKING GARAGE, PART II

Risk Management & Real Options VIII. The Value of Flexibility Stefan Scholtes Judge Institute of...

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